Everyone in business wants to make more money, and one of the best ways to do that is by increasing your marginal profit. But what is marginal profit, and how do you find it?
Marginal profit is the increase in profit an organization makes from selling an extra unit of a good or service. To calculate it, subtract the average cost of producing one unit from the revenue generated by its sale.
Keep reading for insights into how to compute your business’s marginal profit and why it’s a crucial component of your financial plan.
Marginal profit explained: what it is & why it’s important
Marginal profit is the amount of money a business earns from selling one additional unit of a product or service. Put otherwise, it’s the difference in the added revenue and additional cost when an extra unit of a good or service is produced and sold.
Managers and executives use the marginal profit to make decisions about production capacity, marketing campaigns, and other investments.
Here’s a roundup of some of the ways that marginal profit can be used in planning.
To assess whether an opportunity is worth it
One important use of marginal profit in business planning is to assess whether it is worth pursuing a particular opportunity. For example, if a company is considering expanding into a new market, it can estimate the marginal profit the resultant additional sales would generate.
If the marginal profit is low, it may not be worth the investment required to enter the new market. On the other hand, if the marginal profit is high, it may be worth pursuing the opportunity even if it requires a significant investment.
To make strategic decisions
Another important use of marginal profit in business planning is to assess the financial impact of various strategic decisions. For example, a company might compare the marginal profit generated by different advertising campaigns and choose the most effective one.
Similarly, a company might compare the marginal profit generated by different pricing strategies and choose the one that maximizes revenue. By considering the marginal profit generated by various options, companies can make more informed decisions about their business strategy.
To plan for budget allocations
When setting budgets, companies must carefully consider the most important expenses. Marginal profit can be used to determine which budget items should receive the most resources.
For example, a company might decide that marketing expenses are essential and should always be kept at a certain level. Other expenses, like sales commissions, may be more variable and could be cut if profits are lower than expected.
In such a case, estimating the potential marginal gain can help businesses make more informed budgeting decisions.
How to calculate marginal profit
Calculating marginal profit is a three-step process.
1. Determine your fixed costs per unit
Fixed costs are expenses that don’t change no matter how many units you sell. Examples of fixed costs include:
- Operational equipment
Here’s how to calculate your fixed costs per unit:
- Add all expenses that don’t fluctuate based on sales in a given period.
- Divide your total expenses by the number of units you expect to sell in the same duration.
If, for example, your total fixed costs are $5,000 per month and you expect to sell 1,000 units in a given month, your fixed costs per unit are $5.
2. Calculate your variable costs per unit
Now determine your variable costs, which are expenses that increase as you sell more units. Some examples could be:
- Shipping fees
To calculate your variable costs, follow these steps:
- Add all the costs that vary with production in a chosen timeframe.
- Divide the total variable costs by the number of units you expect to produce in that timeframe.
For example, if you expect to spend $500 per month on raw materials to produce 1,000 units in a given month, your raw material variable costs are $0.50 per unit.
3. Subtract the costs from the sales price per unit
Now that you know your fixed and variable costs, calculating your marginal profit should be easy. Here’s the following formula:
Marginal profit = (sales price per unit) – (variable costs per unit) – (fixed cost per unit).
Here’s an example calculation using a restaurant as a case study:
Let’s say a restaurant has fixed costs of $300 per day and variable costs of $15 per plate. Assuming that they sell 100 plates of food per day at $20 per plate, their marginal profit for each additional plate sold would be calculated as follows:
Marginal profit = (sales price per unit) – (variable costs per unit) – (fixed cost per unit)
Marginal profit = ($20) – ($15) – ($300/100)
Marginal profit = $2
The restaurant earns an additional $2 for each plate of food they sell, on top of their fixed and variable costs. Since the marginal profit is high, it would be worth it for the restaurant to continue producing and selling additional food plates.
To put things into perspective, a marginal profit of $2 means the restaurant would earn an extra $200 a day if it doubled daily production. That said, ramping up production may also mean that your variable costs.
The following video gives a brief overview of marginal profit and its relationship with marginal costs:
Marginal profit is a crucial measure of financial performance in business that refers to the additional income generated from selling one extra unit of a product or service. There are many different ways that businesses can use the marginal profit to inform their decision-making, such as:
- Assessing the financial impact of different opportunities and strategies.
- Planning for budget allocations.
- Improving customer service.
Maximizing marginal profit can help businesses grow and make more informed decisions, which is essential for success in any competitive environment.